By RateMarketplace.com Staff
Whether you're borrowing money for home improvements, college tuition or debt consolidation, home equity loans and home equity lines of credit (HELOC) offer attractive tax benefits and interest rates compared to most consumer-loan products. This article answers the question, "What is a home equity loan or line of credit?," and compares the benefits and drawbacks of fixed rate home equity loans and variable rate home equity lines of credit to help you decide which is the best option for your financial situation.
Home equity is the difference between a property's market value and the total amount of the outstanding mortgage debt. For example, if a house is worth $300,000 and the mortgage debt is $180,000, the homeowner has $120,000 of equity in the home.
For the majority of Americans, home equity is their single biggest asset. Borrowers who take out home equity loans on a mortgaged property essentially are putting up their stake in their house as collateral with a lender, who then becomes a secondary mortgage holder.
For that reason, borrowers need to understand a home equity lender can foreclose on a property if they fail to make payments just as a primary mortgage holder can. In recent years, many owners tapped their equity extensively as a ready source of funds, wracked up heavy debt burdens and lost their homes to foreclosure as a result.
Used wisely, however, home equity can be a valuable financial tool -- especially if the loan proceeds are poured back into a house in building an addition or other improvements that increase its value accordingly.Home Equity Loan vs. Home Equity Line of Credit (HELOC)
Home equity loans come in two forms. The first is a traditional fixed-rate loan providing a one-time, lump-sum payment and set payback period, generally 10 to 15 years. The second is a home equity line of credit (HELOC) on which the homeowner can draw as needed and only pay the interest fees until the loan term ends.
Lenders typically let homeowners tap their equity up to 75% to 80% of a home's appraised value. In recent years, some lenders loaned up to 90% to 125% of a home's value at premium interest rates, but most of those programs died with the real estate market's recent collapse.
Fixed-rate home equity loans usually carry an interest rate about two to three percentage points above prevailing 30-year-fixed, first-mortgage rates. Their benefit: The borrower is locked into a rate for the life of the loan, always knows what the monthly payment will be, and pays off the balance by the end of the term. Their downside: With the larger loans often needed for a major home addition, the repayment requirements can make a monthly payment unaffordable for many borrowers.
HELOCs work like a credit card in that borrowers can draw cash by check, account card or electronic transfer up to a certain limit and receive a monthly bill. It is revolving credit in that, as they pay down the balance, they can tap the credit line again through periodic draws.
While a HELOC also runs for a set term, the interest rate charged -- and the monthly payment -- rises and falls with the overall interest-rate environment. Its benefit: The borrower only pays the interest due each month, which allows for borrowing larger amounts for the same monthly payment as a fixed loan. Its downside: At the end of the term, borrowers who made interest-only payments usually must settle up for the entire original loan amount, revert to a fixed-payment schedule for the balance, or apply for a new HELOC with that lender or another.
The HELOC's variable rate itself can be a blessing and a curse depending on the direction and level that interest rates move during the life of the loan. Any variable-rate loan secured by a home must have a cap on how high the rate may rise during the life of the loan. Still, that doesn't necessarily afford much protection since caps may be 18% or more.
Many lenders now offer "float-down" options on fixed-rate loans, where borrowers can get their rate dropped one or more times if interest rates are falling. Some lenders now also offer hybrid loans where the rate is fixed for the first three or five years, with interest-only payments, and then reverts to a variable rate for the remainder of a 10-year period.Tax Deduction
One valuable benefit of home equity loans, as with primary mortgages, is the interest paid is tax deductible. For that reason, these loans can be a good vehicle to consolidate a household's various consumer debts, such as auto loans and credit cards. Home equity borrowers can write off annual interest payments on up to $100,000 worth of general debt, and all the interest on loan amounts used for home improvements.
Caveat emptor: Financial planners warn anyone tapping home equity for debt consolidation to lean toward a fixed-rate loan with a set-payback schedule rather than an interest-only HELOC. Otherwise, they will be moving consumer debt onto a home loan where the balance could be left untouched for 10 years. Additionally, once credit-card balances are cleared, the holder may be inclined to run up balances again on the cards' available credit limits.Costs
The charges involved in applying for a home equity loan are similar to those for a first mortgage. They may include an appraisal fee to determine the value of your home, up-front charges such as points (a point is 1% of the loan amount or credit limit) and closing costs such as attorney, title-search and record-filing fees. Unlike with primary mortgages, many home equity lenders often will absorb all or a major part of those costs to gain a borrowers' business.
One way many borrowers retire home equity loans before their term expires is to roll their first and second mortgages into one new primary mortgage through refinancing when rates drop enough to make a "refi" worthwhile. The balance on a home equity loan, in any case, must be paid off when a home is sold just as with a primary mortgage.For more information about home equity loans and HELOCs, visit the following online resources:
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